The Employee Ownership Update

Corey Rosen

January 31, 2003

A common assumption in the stock options debate is that expensing will drive down the prices of companies that provide options in a more than nominal way, and will be especially hard on companies with substantial options grants. But many people have argued that information about options is already available and, besides, investors care mostly about cash flow and other hard economic measures, not accounting conventions. To probe this issue further, we conducted an e-mail survey of business school finance professors at 30 leading business schools. We received 37 responses. The professors were asked two questions. The questions and the introductory material appear below:

As you know, there have been recent proposals to require companies to expense the present value of option grants to employees as a compensation cost on their income statements. Current rules require companies to show this expense in their footnotes or on their income statements (over 95% choose footnotes). This two-question survey is intended to find out what, if any, impact on stock prices economists expect this change to have.

1. Which of these statements comes closest to representing your views about the short-term impact on stock prices of requiring companies to expense the present value of option grants to employees as a compensation cost on their income statements?

a) It will have no significant impact on stock prices because the market already has incorporated this information. b) It will have a small impact on stock prices. c) It will have a substantial impact on stock prices. d) It will have a small impact on stock prices of companies with options expenses larger than industry norms. e) It will have a large impact on stock prices of companies with options expenses larger than industry norms.

2. Do you think companies should expense options? a) Yes b) Yes, but current accounting proposals for expensing are unrealistic. c) No d) Other

On question 1, 14 people answered a, 7 answered b, 2 answered c, 10 answered d, and 4 answered e. In other words, only six of the respondents expected that expensing will have a substantial impact on stock prices for any of the companies with options. The remaining 31 respondents expected either no impact or a small impact. The respondents did, however, think companies should expense options. Twenty-eight respondents chose a, five chose b, three chose c, and one chose d.

So what can we make of this limited research? These experts seem to think that expensing might turn out to be the "Y2K" problem of stock options, much feared but of little consequence. Of course, it is impossible to predict how the market will respond with any precision, but, at this point, it seems that it would be safer to bet that the impact will be nominal. If this is the case, companies should certainly not make wholesale changes in their plans just to respond to a non-existent problem. Instead, they should design their equity compensation so that it serves their real economic and human resource needs, not their accounting convention needs.

Retirement Plan Reform Stirs Again

Leaders in both parties have indicated they plan to move retirement plan reform bills this year. In the House, John Boehner (R-OH) will reintroduce the Republican bill he shepherded through that House last year. In the Senate, Tom Daschle (D-SD) will push a comprehensive Democratic bill (S. 9) that combines retirement reform with other Democratic economic issues. Given Republican control of the Senate, however, something closer to the House bill is much more likely to emerge from the relevant Senate committees. None of the provisions likely to survive in any bills would have a substantial effect on ESOPs. The bills would, however, give employees in 401(k) plans greater flexibility in moving investments out of company stock. One major sticking point between the House and Senate is likely to be a difference in investment advice provisions. The House favors providing fiduciary exemptions for companies that hire plan providers to give advice to participants; the Senate favors the exemption only for independent advisors.

Houghton Bill Would Exempt Options from Employment Tax

Amo Houghton (R-NY) has introduced H.R. 286, a bill to permanently exempt gains from exercises of incentive stock options and employee stock purchase plan options from payroll taxes. The IRS has delayed implementation of a rule to impose the taxes indefinitely. Houghton has 29 cosponsors.